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Ethiopia’s recent political turmoil could expose some of the country’s structural economic weaknesses

Event

On 15 February 2018 the Ethiopian Prime Minister Hailemariam Desalegn, who had been in power since 2012, resigned. Two days later, a state of emergency was declared. The resignation of the Ethiopian Prime Minister followed upon protests that resurfaced in recent months. These protests are driven by the Oromo and Amhara ethnic groups which demand for greater democracy, adherence to the rule of law and the end of the dominance of the ruling Tigrayan elite.

Impact on country risk

Protests – that initially started in October 2016 - erupted spontaneously after the government announced plans to expand the territory of the capital Addis Ababa into the territory of Oromia. The Oromos then formed a united front with the Amhara people against the Tigrayan elite. Historically both ethnic groups have always felt discriminated: while the Tigrayans make up only an estimated 6% of the population they hold strong control over the Ethiopian politics, economy and military.

The initial response of the government to the protests was repression and the declaration of a state of emergency that lasted until August 2017. This resulted in mass arrests and the killing of hundreds of protesters. While it succeeded in tempering the protests, it did not solve underlying problems but led to increased tensions within the Ethiopian People’s Revolutionary Democratic Front (EPRDF) that has ruled the country for 27 years. On top of these unprecedented protests, strong internal division within the coalition, between a fraction that wants to increase regional power and a fraction that favours increased central control, takes place and makes it even more difficult to formulate a clear response to the current crisis. By now, the government response to the crisis has been inconsistent.

In January, the government decided to release a large number of political prisoners. This was interpreted as an indication that the EPRDF recognises that repression was inefficient in stopping the protests and was willing to implement genuine reforms for the first time since they seized power in 1991. However, the current decision to re-impose the state of emergency strongly contrasts with previous actions. On the contrary, it seems to indicate that hardliners within the ruling coalition are currently gaining the upper hand. This could be due to the fact that from the government’s point of view the freeing of political prisoners has done little to quell the protest.

It is difficult to predict how the current situation will evolve, but the stakes are high. Indeed, if the government is willing to respond to the current protests in the same way as it did during the last state of emergency, it is likely to lead to an escalation of the crisis rather than to its resolution. Secondly, any escalation of the current situation could have significant economic consequences.

In terms of economic growth, the country has been outperforming all other countries in East Africa. Growth averaged 9.9% in the last decennia, which is significantly higher than in Tanzania (6.8%), Kenya (4.9%), Uganda (5.4%) or Rwanda (7.4%). However, growth has been mainly driven by state-led initiatives and foreign investments in specific sectors such as garment manufacturing as well as by (state-led) infrastructure investments. Consequently the country has run a structurally large current account deficit which reached 8.2% of GDP in the fiscal year (FY) 2017 (Starting on 8 July 2017) and is expected to decrease slowly in the coming years towards around 6% by 2021.

In the past, the current account deficit was mainly funded through public external borrowing, but in recent years foreign direct investments have become more important. The problem is that both ways of funding the current account deficit currently risk being under pressure.

Current protests have the potential to derail the strong foreign direct investment inflows into the country. For their part, past protests had been directed towards foreign investors and associated land leases, which is likely to remain the case. Nevertheless, this has not yet led to a drop in foreign direct investments in FY 2017 as seen in graph 1. At the same time, it should be noted that last year’s significant increase in foreign direct investments could largely be attributed to the newly opened industrial parks and to the sale of part of the National Tobacco Company to foreign investors in 2017.

Public external borrowing is currently already under pressure given that Ethiopia has only very limited room to further increase external borrowing. Over the years, the country has built up significant external debt due to the borrowing associated with the country’s large-scale infrastructure projects. While the country’s external debt is relatively low when expressed as a share of GDP (31.9% of GDP in FY 2017) it is very high when compared to the country’s current account receipts (233.4% of current account receipts in FY 2017). This reflects Ethiopia’s weak exports. Thus, similarly to Kenya, Graph 2 shows a strong growth in external debt, but a much slower growth in current account receipts. The slowdown in export receipts in FY 2017 in combination with the high external debt led the IMF to classify Ethiopia at a high risk level of debt distress in its latest debt sustainability analysis (December ’17). Last year the authorities already acknowledged the increased risk of the debt build-up and, in accordance with the IMF, Ethiopia already slowed down external borrowing in FY 2017.

The combination of the potential risk that the political crisis poses for foreign direct investments and the country’s low ability to further expand public external borrowing increases pressure on foreign exchange reserves, which have already been under pressure in recent years. The country has held structurally low foreign exchange reserves for a number of years (they have always averaged around 2 months of import coverage, which is regarded as low). In the beginning of the year, foreign exchange shortages motivated Credendo to downgrade its short-term political risk classification in March 2017. And, it is positive to see that the government responded to this by devaluating the Ethiopian birr by 15% in October 2017. However, while it reduced the currency overvaluation, and is likely to reduce pressure on the foreign exchange reserves, there remains an increased risk of foreign exchange shortages in the country in the coming months.